Distressed fund issues: The director’s perspective
A fund may get into financial difficulty for many reasons including poor performance, fraud, mismanagement, the redemption of a key investor or as a result of litigation. In some cases the situation may have developed over time while in others it might be a single event or change which triggers the problem.
Often in these cases a fund will struggle on in the hopes that the situation will improve, however, this can result in the fund eventually becoming insolvent. While solvency is defined slightly differently in various jurisdictions, in the Cayman Islands the Companies Law refers simply to the cash flow test, which is the ability of the fund to pay its debts as they fall due.
In between a company being clearly solvent and failing the cash flow test, is often a period of doubtful solvency, where directors and management aim to turn the fund around. This is often referred to in industry parlance as the “Twilight Zone” of operation.
Duties and obligations
When a fund is solvent, the directors, in discharging their obligations to the fund, generally are expected to have regard to the interests of the investors. However, when a fund becomes insolvent or is near insolvency, the directors must have regard primarily to the interests of the fund’s creditors.
As such, during this period, the fund could, through continued operation, breach lending covenants or risk a winding up petition by its creditors. Directors should also note that transactions entered into during this period may be set aside by the courts and the directors could risk personal liability for the fund’s debts.
Given these potential consequences, it is critical to have directors that fully understand their duties and obligations and to obtain advice from corporate recovery specialists when in these grey areas of operation.
It is of further importance that directors of a fund in distress obtain accurate, detailed and regular financial and portfolio information in order to properly monitor the fund and ensure that it remains solvent. The directors must consider this information and satisfy themselves that there is a reasonable prospect of avoiding insolvency and that the fund is able to continue as a going concern. If at any point the directors cannot reasonably conclude this is indeed the case, they have a duty to minimise the potential loss to creditors. Failure to do so could lead to the directors being personally liable for the fund’s debts.
It is important to note that where meetings are held by directors to consider a fund’s solvency, a record of what was reviewed and advice considered should be kept as this may be required as evidence to support that the board considered the appropriate information and acted accordingly.
It is also extremely important not to worsen the position of creditors if a fund becomes insolvent. If the directors of a fund know, or should have known, it was insolvent and allow the fund to continue trading, they could be found personally liable if new creditors were created, existing credit obligations were increased or if assets that would have otherwise been available to pay creditors were not preserved.
Practically speaking this means that directors should not allow any fund that they believe may be nearly insolvent to continue trading without fully considering the ability of the fund to meet its obligations as they fall due.
Directors should also keep in mind that resigning will not protect a director from liability for breaches and in fact it might even make the situation worse if the director could in fact have done something further to minimise potential creditor losses.
Fund structure implications
Matters may be further complicated if a fund in difficulty is part of a larger fund structure or group of funds. Issues can be particularly tricky, if the group is solvent and managed as a single structure. Agreements that are practical and defensible within a solvent group may cease to be when a fund within the group becomes insolvent.
In these cases the directors of each fund must act in relation to that fund without regard to their duties as directors of other group funds. Directors must also be alive to the possibility that the duties owed to the various funds in a group may in fact conflict and it may therefore be necessary to appoint new directors to the distressed fund in order to effectively remove these conflicts.
One should also consider that the vast majority of fund structures in the Cayman Islands have at least one entity subject to regulatory oversight by the Cayman Islands Monetary Authority. It is therefore important that directors understand that they will also be subject to regulatory scrutiny while operating a distressed fund.
CIMA have wide ranging powers with respect to regulated funds, including the ability to issue winding up petitions or to appoint controllers over regulated entities, and it is therefore important to manage and track communication with the regulator.
Upon identifying that a distressed fund situation has arisen, there are several options that directors have at their disposal. These include seeking expert assistance, applying for a provisional liquidation or seeking an official liquidation.
When a fund starts to face problems or issues that could ultimately lead to a distressed situation or insolvency, the directors may determine that they do not have the requisite skills or time available to sufficiently oversee the operations.
A solution is to have professional directors with experience restructuring funds replace, or added to, the current board to ensure that the relevant laws and guidelines are complied with as well as reducing the risk to the incumbent directors.
This option allows a distressed fund to try to work through the various issues to restore solvency, while effectively managing the increased risk to directors of operating a nearly insolvent fund.
If a solvent solution cannot be found, the fund may apply to the Cayman Court by presenting a winding up petition and applying for the appointment of provisional liquidators. A provisional liquidation is a “soft touch” insolvency process which the Cayman Court will order on the basis that it promotes a restructuring of the company’s affairs through the mechanism of a scheme of arrangement with its creditors.
In many cases, a restructuring or scheme of arrangement may not be feasible. In these circumstances, a “full blown” liquidation may be inevitable. If so, the directors may have a choice to appoint liquidators by applying directly to the Cayman Court or by recommending to the voting shareholders that they pass a resolution that the fund be wound up voluntarily.
If the directors, after consultation with an insolvency accountant or lawyer, are of the opinion that the fund cannot be rescued, but consensus is not reached with the shareholders, the next step would be to apply to Court with a winding up petition. Further, in a recent case, the Cayman Court ruled that directors of an insolvent company had standing to cause that company to petition the Cayman Court for a winding up order, absent a resolution of its members.
In situations where there is agreement between the directors and voting shareholders, a more cost effective approach may be to recommend that the shareholders pass a resolution to appoint voluntary liquidators. Given that the fund is insolvent or of doubtful solvency, the directors will be unable to execute a declaration of solvency and the voluntary liquidators will be required to seek a supervision order from the Cayman Court.
Given the complexity of the issues and the potential for personal liability, directors of funds that may be in or near the so called “Twilight Zone” would be wise to seek advice from appropriate experts, including corporate recovery specialists and legal counsel.